6/20/2006 @ 4:00PM

Mind The (CEO Pay) Gap

It’s conventional wisdom in the executive suite: When CEOs go to London, they have to watch what they spend. That’s not because of the weak dollar. Rather, CEOs in the United Kingdom just don’t make as much as their American counterparts.

The size of the gap, however, is up for debate. A study by consulting firm Towers Perrin found that American top dogs make 80% more than their brethren in Britain. Another consultancy, Hay Group, has found a 50% gap.

But a recent study–by academics, not consultants–says the gap is much smaller than previously thought. Martin J. Conyon, John E. Core and Wayne R. Guay, all professors at the University of Pennsylvania’s Wharton School of Business, compared the largest 250 British companies with about 1,200 U.S. firms of similar size. Both the Towers Perrin and Hay studies, by contrast, used much smaller samples.

In 2003, according to the Wharton data, the median U.S. CEO pay package was about $2.5 million, including salary, bonuses, benefits and incentive compensation. That was 35% more than the median British CEO, who brought home a little less than $1.9 million.

And the gap is shrinking. In 1997, the median U.S. chief executive made about $2 million, or more than twice as much as his counterpart in the U.K., according to the Wharton study, which hasn’t been published yet. The pay gap narrowed despite the fact that U.S. firms grew much faster than British companies during that period, the researchers say.

Compensation consultants aren’t surprised by this convergence. All over Europe, they say, executives are demanding American-sized pay packages. Instead of just cash, European executives are now expecting incentive compensation like restricted shares and stock options, which can result in much higher pay packages.

Meanwhile, U.S. companies have pulled back on their use of incentive compensation, partly because of corporate scandals earlier in the decade and partly because of a change in accounting rules that require stock options to be treated as an expense. As a result, pay packages in rich countries are starting to converge.

In other words, American CEOs, like ordinary workers, are now subject to competition from cheaper foreign labor. Of course, CEOs in India and Malaysia won’t be making as much as Capital One Financial‘s
CEO Richard D. Faribank ($249 million last year) or
Yahoo!
CEO Terry Semel ($231 million) any time soon.

But Bob Wesselkamper, director of consulting firm Watson Wyatt’s international practice, says executive-pay growth in the U.S. will start to slow. “It’s got to,” Wesselkamper says. “A soft landing in CEO pay is likely to occur, just as we see in other aspects of our global economy.”

Brent Longnecker, an executive compensation consultant and president of Longnecker & Associates, says he has been in meetings with British, German, Japanese, Australian and French executives complaining about the pay gap. “They don’t want to feel like they left money on the table,” Longnecker says. Because of the shared language, British CEOs are particularly well positioned to threaten to leave their firms for more lucrative U.S. jobs.

But America’s bigger pay packages come with bigger risks, says Guay, a Wharton accounting professor. American CEOs own eight times as much stock in their firms as British CEOs. Their pay packages also include a greater proportion of stock.

Guay and his colleagues say this risk explains most of the cross-Atlantic pay gap. “If [companies] want these individuals to hold so much of their wealth in firm stock, there is a premium to be paid,” says Guay.

Conventional wisdom, by contrast, blames the pay gap on weaker corporate governance in the U.S. British shareholders vote on executive compensation packages; while the votes are nonbinding, companies often abide by their outcomes. In the U.S., by contrast, shareholder demands for a larger say in executive compensation have mostly been ignored.

The Wharton researchers weren’t satisfied with that explanation. After all, if American firms are so horribly governed, why do they perform so well? “We’re not claiming there aren’t some people you can find with governance problems,” says Core, also in Wharton’s accounting department. “All we’re saying is, for 90% of these folks, there’s nothing wrong.”

But the risk rationale might not work with shareholders and governance watchdogs who are critical of enormous pay packages. Paul Hodgson, a senior research associate at the Corporate Library, which collects executive-pay data, notes that few executives use their own cash to purchase company stock; the shares are granted to them as part of their pay packages. “It’s not as if they’ve taken their own cash earnings and invested it in the company’s stock,” Hodgson says.